Startups Are a Beauty Contest

One of the hard truths in startups, especially VC funded startups, is that perception matters more than reality. Many people are able to raise vast amounts of money at high valuations on little more than excitement about the prospect of a viable business some time in the future.

Most VCs earn their living from fees, and they earn more in fees when valuations go up, followed by subsequent funding rounds, with larger amounts of capital invested. VCs don’t usually invest their own money, they typically invest other people’s money. Thus, they aren’t really incentivized to see their companies succeed, but rather they want to make their companies appear successful. That is to say, the perception of success matters more than actual success.

Consider WeWork, which at its peak reached a valuation of $47 billion despite never having turned a profit. The company mastered the art of storytelling and perception management, convincing investors it was a revolutionary tech company rather than a real estate business with fancy branding¹. When reality eventually caught up, its valuation collapsed, but not before early investors and executives extracted billions.

This is a topic Keynes wrote about in his General Theory of Employment, Interest and Money. He compared professional investment to newspaper competitions where readers had to pick the six prettiest faces from a hundred photographs, with the prize going to the reader whose selection most closely matched the average preferences of all competitors. From Wikipedia:

It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.

In startup investing, this manifests as VCs not necessarily backing what they believe are the best businesses, but what they think other VCs will think are valuable in future funding rounds. It’s why certain buzzwords (AI, blockchain, SaaS) can trigger funding frenzies regardless of underlying business fundamentals.

This also applies to the entire stock market, which is more akin to a Ponzi scheme than anything. People buy stocks because they think they will be able to sell them for more than they paid for them, at some point in the future.

When companies aren’t being valued based on their current revenue, or dividends, or any other “fundamental” metric, then you’re merely speculating that some fool down the line will be willing to pay more than you for the same magic beans you just bought.

The phenomenon creates strange incentives. Startup founders are encouraged to prioritize growth over profitability, to chase metrics that look good in pitch decks rather than building sustainable businesses. Companies burn cash on acquiring users with no clear path to monetization, because what matters is the story they can tell about future potential.

Interestingly, there’s historical precedent for this behavior. During the South Sea Bubble of 1720, one company actually raised money by advertising itself as “a company for carrying out an undertaking of great advantage, but nobody to know what it is.”² The entrepreneur raised £2,000 in a single morning before disappearing. Today’s equivalent might be the countless ICOs of 2017-2018 that raised millions on nothing but a whitepaper.

So what’s the solution? Perhaps we need investment structures that align incentives better – where investors and founders both succeed only when the business creates actual value. But as long as there’s money to be made in the beauty contest, it’s unlikely the game will change.